Valuations

Feature Conditions are falling into place in Brazil that will facilitate a recovery in physical property prices as well as the outperformance of real estate stocks. With the overall Brazilian equity index having rallied considerably, investors are now wondering which sectors of the market presently offer the most upside with the least risk. Our bias is that the risk-reward of property stocks is currently attractive both relative to the overall equity index as well as in absolute terms (Chart I-1). Chart I-1Good Risk-Or-Reward In Property Sector Good Risk-Or-Reward In Property Sector Good Risk-Or-Reward In Property Sector As such, we recommend investors begin accumulating Brazilian real estate stocks on weakness and other proxies that stand to benefit from a revival in both residential and commercial property markets. The Macro Case For Real Estate Following years of severe depression, fertile ground for strong growth in Brazilian real estate and related assets is finally developing: Interest rates are falling, employment and incomes are rising, and credit availability is improving amid substantial pent-up demand for properties. Barring an outright failure by the government to adopt pension reforms, which would cause major financial market turbulence, the economy will continue on a recovery path (Chart I-2). Please see page 7 for more details. Chart I-2Domestic Demand Bottoming... Domestic Demand Bottoming... Domestic Demand Bottoming... We upgraded our recommended allocation in Brazil from underweight to overweight across equity, fixed-income, currency and credit markets right after the October elections.1 We argued that the presidential election victory by pro-business candidate Jair Bolsonaro was set to revive sentiment and “animal spirits” among businesses, unleashing pent-up demand for capital expenditures and hiring. On the whole, the Brazilian economy is recovering from the most severe economic depression of the past several decades (Chart I-3). Consequently, there is a lot of pent-up demand for discretionary spending in general and properties in particular. Chart I-3...After The Worst Recession In Decades ...After The Worst Recession In Decades ...After The Worst Recession In Decades Our view remains negative on Chinese growth and commodities. Historically, Brazilian financial markets have never sustainably diverged from commodities prices, as illustrated in Chart I-4. Nevertheless, going forward the odds that Brazilian domestic plays could decouple from commodities prices are non-trivial. Chart I-4Can Brazilian Financial Markets Decouple From Commodities? Can Brazilian Financial Markets Decouple From Commodities? Can Brazilian Financial Markets Decouple From Commodities? Importantly, aggregate exports make up only 13% of Brazilian GDP (Chart I-5). This indicates that Brazil’s exposure to global demand in general and commodities in particular is not substantial. Besides, Brazil’s commodities exports are very diversified – overseas shipments of each commodity accounts for only a small portion of Brazilian exports and GDP (Table I-1). Chart I-5Brazil Is A Closed Economy! Brazil Is A Closed Economy! Brazil Is A Closed Economy! Chart I- In Brazil, the property market is one of the few sectors that is least exposed to global growth and most leveraged to local interest rates and household income growth. Hence, this sector stands to outperform in a scenario where global cyclicals and commodities fare poorly while domestic income and spending recover. Notably, real estate is the most leveraged play on falling real interest rates. The rationale for why real estate is more sensitive to real rather than nominal rates is as follows: Property prices benefit from higher inflation – higher inflation lifts nominal household income, which improves affordability for buyers and renters. In addition, investors often buy properties as an inflation hedge. Provided property prices positively correlate with inflation but negatively correlate with nominal interest rates, it follows that they are very strongly inversely correlated with real (inflation-adjusted) interest rates. Confirming this, relative performance of property stocks to the overall market tracks real interest rate trends very closely (Chart I-6) Chart I-6Lower Real Rates Warrant Real Estate Stocks Outperformance Lower Real Rates Warrant Real Estate Stocks Outperformance Lower Real Rates Warrant Real Estate Stocks Outperformance Yields on inflation-indexed bonds – real rates – have recently broken down (Chart I-7). If Congress adopts social security reforms in the coming months, real interest rates could drop further. Chart I-7Real Rates Have Fallen To All-Time Lows Real Rates Have Fallen To All-Time Lows Real Rates Have Fallen To All-Time Lows In short, falling real rates will greatly benefit real estate prices and volumes. Some commentators might argue that Brazil’s low national savings rate will preclude real rates from falling. We discussed why a low national savings rate is not an impediment to a decline in real interest rates in our March 22, 2018 Special Report (please click on the link to access the report). Property Market: Post Depression… The majority of excesses have been wrung out of the physical property markets in Brazil over the past 5-6 years, and real estate prices and volumes are finally showing signs of recovery. Residential property prices have been flat in nominal terms over the past 5 years. Yet in real (inflation-adjusted) terms they have declined by 20%, and in U.S. dollar terms they are down 40% from their 2014 peak (Chart I-8). Chart I-8Apartment Prices Have Been Beaten Down Nationwide Apartment Prices Have Been Beaten Down Nationwide Apartment Prices Have Been Beaten Down Nationwide Property sales and prices in São Paulo have already begun rising, but not in Rio de Janeiro (Chart I-9). Typically, bull markets begin in financial and business centers and then spread to other cities and regions. Chart I-9Brazil: Apartment Prices Brazil: Apartment Prices Brazil: Apartment Prices Over the past two days, during our visit to clients in São Paulo, we witnessed very few cranes. Even in this financial and business center, property construction/supply remains extremely subdued. Vacancy rates in office spaces, residential property inventories, and the average sales time are all starting to fall (Chart I-10). These are all early signposts of revival. Chart I-10Signs Of Life Signs Of Life Signs Of Life Notably, the consumer debt-servicing ratio has fallen due to lower interest rates (Chart I-11). Mortgage rates remain high relative to the (SELIC) policy rate. However, odds are that this spread will narrow as confidence and appetite for mortgage lending among banks improves. Chart I-11Diminishing Household Debt Stress Diminishing Household Debt Stress Diminishing Household Debt Stress Bottom Line: Overall residential property prices across Brazil’s 11 largest metropolitan areas are slowly starting to rise in nominal but not in real terms yet (Chart I-12). The recovery is only beginning to take shape. Chart I-12Property Price Deflation Is Ending Property Price Deflation Is Ending Property Price Deflation Is Ending Pension Reforms Hold The Key At the moment, we believe pension reforms – not commodities prices – are the key to sustaining the positive momentum behind Brazil’s financial markets and economy. If Bolsonaro introduces pension legislation immediately, while his political capital is still high, then it will be a market-positive development. However, it is difficult to determine the odds of the passage of the social security reform bill, and the form in which it will be adopted. On one hand, the Brazilian Congress is as fragmented as ever. Bolsonaro’s PSL party holds only 52 seats, or 10% of the total. This means that the president has to convince 256 congressmen outside his party to vote for pension reforms in order to get the 308 votes required to pass this constitutional amendment (Chart I-13). His attempt to find a new way to form a coalition may backfire, at least initially, and he will also face obstructionist voting behavior from minor parties. Chart I-13 On the other hand, Brazilian presidents eventually tend to succeed in forming coalitions that comprise a majority of seats. On paper, right-leaning parties have slightly more seats than the three-fifths majority needed for constitutional changes in the Chamber of Deputies. Moreover, many congressmen are new faces in politics and represent small parties. They have little political experience and may not go against a popular president at the very early stages of their congressional terms. It is reasonable to assume that they could side with the president and vote for the pension reforms, for several reasons: (1) distancing themselves from Bolsonaro may not help their own popularity; and (2) voters may well be focused on issues other than unpalatable pension reforms four years from now if the economy is doing well. Hence, voting for the pension reforms early in their term may be a reasonable political strategy for them. Importantly, it seems these reforms have the initial backing of both the military and the police establishments, even though their pensions will be negatively impacted by the changes. Specifically, Vice President and retired general Hamilton Mourão has hinted at the army’s and police’s support of the upcoming social security reforms proposal. In brief, the adoption of pension reforms will create positive tailwinds for investor and business sentiment and in turn support the economic recovery. Investment Recommendation Brazilian stocks have lately exhibited a low correlation with the EM overall equity index. This gives us comfort in arguing that even if our negative view on EM risk assets plays out, Brazilian domestic equity plays will likely have only moderate downside in absolute terms, and certainly outperform the EM equity benchmark on a relative basis. Therefore, we recommend investors begin accumulating Brazilian real estate stocks on weakness. Even though their valuations are not cheap, rising revenue and cash flow will improve their valuation metrics and boost their share prices. With respect to sector composition, the Brazilian real estate sector is comprised of 27 listed firms: 15 listed homebuilders, 7 mall operators, 3 commercial properties and 2 brokers.2 Their total market cap relative to the Bovespa is now around 1.2% – down from 2.4% in 2012 (Chart I-14). We recommend buying a mix of these companies to gain exposure to various parts of the Brazilian property market. Chart I-14More Upside In Real Estate Stocks bca.ems_sr_2019_01_24_s1_c14 bca.ems_sr_2019_01_24_s1_c14   Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018, available on page 12. 2      We used the BM&FBOVESPA Real Estate Index (IMOB) in Chart 14. The Real Estate Index (IMOB) is compiled as a weighted average of 13 stocks. For more detail, please refer to: http://www.b3.com.br/en_us/market-data-and-indices/indices/indices-de-segmentos-e-setoriais/real-estate-index-imob.htm Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Recent Changes Initiate a long S&P homebuilding/short S&P home improvement retail pair trade today. Table 1 Dissecting 2019 Earnings Dissecting 2019 Earnings Feature Equities have retraced 50% of the peak-to-trough losses, and are still consolidating the post December Fed meeting tremor. Chart 1 shows that the VIX has been cut in half and the high-yield corporate bond option-adjusted spread has dropped 105bps. Retrenching volatility and deflating junk spreads suggest that the equity risk premium (ERP) remains uncharacteristically high. The path of least resistance is for the ERP to narrow in the coming months as we do not foresee recession in 2019. As a reminder, the ERP and the economy are inversely correlated. Chart 1Risk Premia Renormalization Risk Premia Renormalization Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A positive U.S./China trade resolution A continuation of the earnings juggernaut With regard to the macro related catalysts, an update to our reflation gauge (RG) is in order. The trade-weighted U.S. dollar has been depreciating since early November, the 10-year U.S. Treasury yield has come undone since the early November peak and oil prices are 33% lower than the early-October peak. These three variables comprise our RG and the signal is unambiguously bullish. In other words, a reflationary impulse looms in the months ahead which should pave the way for a rebound in both plunging investor sentiment and the gloomy economic surprise index (RG shown advanced, Chart 2). Chart 2Reflating Away Reflating Away Reflating Away On the earnings front, last week we trimmed our end-2020 SPX EPS forecast to $181 while we sustained the multiple at 16.5 times which resulted in a 3,000 SPX target.1 Drilling beneath the surface and analyzing the composition of SPX profits is revealing. Table 2 highlights sell side analysts’ profit levels and growth projections on a per GICS1 sector basis and also their contribution to overall earnings along with each sector’s projected earnings weight and most recent market capitalization weight. Table 2S&P 500 Earnings Analysis Dissecting 2019 Earnings Dissecting 2019 Earnings Chart 3 shows that financials, health care and industrials are responsible for 61% of the SPX’s profit growth in 2019. Interestingly, technology’s contribution has fallen to a mere 7.2% and even if we add the new communication services sector’s 9.6% contribution it still falls well shy of the tech sector’s market cap and earnings weight. Another worthwhile observation is that energy profits are no longer off the charts, as base effects since the early-2016 $25/bbl oil trough have filtered out of the dataset. Chart 3 While the risk of disappointment surrounds financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 4 & 5). In addition, if our Commodity & Energy Strategy service’s bullish oil forecast pans out this year, the negative energy sector contribution to SPX profit growth will get a sizable upward revision (please look forward to our GICS1 sector EPS growth models updates and profit margin analysis in next week’s report). Chart 4Earnings Revisions... Earnings Revisions... Earnings Revisions... Chart 5...Really Weigh On Tech ...Really Weigh On Tech ...Really Weigh On Tech ​​​​​​​ In sum, if the Fed pauses its hiking cycle through at least the first half of the year, we see a positive U.S./China trade resolution and SPX profits sustain their upward trajectory, then the SPX budding recovery will morph into a durable rally. This week we are updating an interest rate sensitive index that is highly levered to the surging U.S. credit impulse (Chart 6) and are initiating an early cyclical intra-sector and intra-industry pair trade. Chart 6Heed The U.S. Credit Impulse Signal Heed The U.S. Credit Impulse Signal Heed The U.S. Credit Impulse Signal Stick With Banks While our overweight call in the S&P banks index suffered a setback last month, since inception it has moved laterally, and we continue to recommend an above benchmark allocation to this key financials sub group. Not only are the odds of recession low for this year, but narrowing credit spreads and a reversal in financial conditions are also waving the green flag (junk spread shown inverted & advanced, bottom panel, Chart 7). Chart 7Bank On Banks Bank On Banks Bank On Banks Unlike the previous three reporting seasons when banks revealed blowout numbers and stocks subsequently fell, this season some profit and top line growth misses have been greeted with rising bank stocks prices. Such a reaction suggests that the worst is behind this sector and a sustainable recovery looms. Importantly, on the loan growth front, our credit impulse diffusion index is reaccelerating (Chart 6) and the overall credit impulse is expanding (middle panel, Chart 7). Our total loans & leases growth model and BCA’s C&I loan growth model both corroborate this encouraging credit backdrop (second & bottom panels, Chart 8). The latter is significant given that C&I loans are the single biggest credit category in bank loan books (Chart 9). Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Chart 8Credit Models Flashing Green Credit Models Flashing Green Credit Models Flashing Green Chart 9Credit Models Flashing Green C&I Loans Leading The Pack C&I Loans Leading The Pack Multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 8). The outlook for the second largest credit category, residential real estate, remains upbeat in spite of last quarter’s soft housing related data releases. The recent easing in monetary conditions has breathed life back into the mortgage purchase applications index and also house prices continue to expand at a healthy pace (Chart 10). The upshot is that first-time home buyers will show up this spring selling season. Chart 10Residential Loans Also On Solid Footing Residential Loans Also On Solid Footing Residential Loans Also On Solid Footing Beyond positive credit growth prospects, credit quality remains pristine. BCA’s no recession in 2019 view remains intact, thus NPLs and chargeoffs should stay muted. As a reminder, U.S. banks are the best capitalized banks in the world,2 and their reserve coverage ratio has returned to 124%, a level last seen in 2007 (Chart 11). Chart 11Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Another important source of support is equity retirement. Banks have been late to the buyback game as the GFC along with the new strict bank regulatory body, the Fed, really tied their hands with regard to shareholder friendly activities. In fact, according to flow of funds data, the financial sector is still a net equity issuer, albeit at a steeply decelerating pace especially relative to the non-financial corporate sector (Chart 12). Pent up financial sector buyback demand is a boon for bank EPS growth. Chart 12Pent Up Buyback Demand Getting Unleashed Pent Up Buyback Demand Getting Unleashed Pent Up Buyback Demand Getting Unleashed This is significant at a time when analysts have been swiftly downgrading EPS growth figures for the SPX. Encouragingly, our bank EPS growth model captures all these positive forces and while it is decelerating it still suggests that profit growth will be stellar in 2019 and easily outpace the overall market (Chart 13). Chart 13Banks EPS Growth Will Outpace The Market Banks EPS Growth Will Outpace The Market Banks EPS Growth Will Outpace The Market Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that a re-rating phase looms (Chart 14). Chart 14Rerating In Still In The Early Innings Rerating In Still In The Early Innings Rerating In Still In The Early Innings Nevertheless, there is one headwind banks face as the business cycle is long in the tooth and on track to become the longest expansion on record: the price of credit. One reason for the deflating relative stock price ratio since the January 2018 peak has been the yield curve slope flattening (Chart 15), as it suppresses bank net interest margins. Banks have been fighting this off partly by keeping their source of funding ultra-low judging by still anemic CD rates, according to Bankrate’s national average (bottom panel, Chart 15). Chart 15One Minor Headwind One Minor Headwind One Minor Headwind While yield curve inversions have widened all the way out to the 7/1 slope, the key 10/2 slope has yet to invert. Were the 10-year U.S. treasury to resume its selloff, even a mild yield curve steepening will go a long way, as BCA’s bond strategists expect. Clearly a flattening curve is a risk to our sanguine bank view, but the rest of the positives we outlined above more than offset the yield curve blues. Adding it all up, vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of the 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Bottom Line: Maintain the overweight stance in the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC, . Buy Homebuilders/Sell Home Improvement Retailers While we reiterate our recent overweight call on the S&P homebuilding index3 and the high-conviction underweight call on the S&P home improvement retail (HIR) group,4 it also makes sense to initiate a market neutral trade: long homebuilders/short HIR. This pair trade is levered on the swings of residential construction compared with residential investment. Currently the former is significantly outpacing the latter and suggests that relative share prices have ample room to run (top panel, Chart 16). Chart 16A Play On Residential Construction Vs. Investment A Play On Residential Construction Vs. Investment A Play On Residential Construction Vs. Investment Put differently, this share price ratio moves in tandem with homebuilders breaking new ground versus home owners renovating their existing house. Chart 17 shows the NAHB’s homebuilder sales expectations survey compared with the remodeling expectations survey. This relative sentiment gauge has ticked up recently, confirming the message from national accounts that residential construction has the upper hand over residential investment. The upshot is that the bull market in relative share prices is in the early innings. Chart 17Relative Survey Expectations... Relative Survey Expectations... Relative Survey Expectations... Keep in mind that housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (middle & bottom panels, Chart 16). More specifically on the interest rate front, while both groups move with the oscillation of lending rates, new home sales are more sensitive than HIR sales to the price of credit. Our proxy of mortgage application purchase to refinance index does an excellent job in capturing this relative interest rate sensitivity and the recent jump signals that a catch up phase looms in the relative share price ratio (top panel, Chart 18). Chart 18...Easing Interest Rates... ...Easing Interest Rates... ...Easing Interest Rates... Relative loan growth activity also corroborates that demand for residential real estate is outpacing demand for home renovation (bottom panel, Chart 18). Beyond these macro tailwinds for this intra-sector trade, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. In other words, rising lumber prices are a boon for HIR and a bane to homebuilders and vice versa. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (Chart 19). Chart 19...And Cheapened Lumber Prices Favor Homebuilders Over HIR ...And Cheapened Lumber Prices Favor Homebuilders Over HIR ...And Cheapened Lumber Prices Favor Homebuilders Over HIR Finally, oversold relative technicals, depressed valuations and extreme sell side analysts’ relative profit pessimism, offer a very compelling entry point in the pair trade for fresh capital (Chart 20). Chart 20Oversold And Unloved Oversold And Unloved Oversold And Unloved Netting it all out, rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and relative alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Bottom Line: Initiate a new long S&P homebuilding/short S&P home improvement retail pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: S5HOME – DHI, LEN and PHM, and BLBG: S5HOMI – HD and LOW, respectively.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com footnotes 1 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, “Top 10 Reasons We Still Like Banks” dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “2019 Key Views: High-Conviction Calls” dated December 3, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights MLPs’ one-of-a-kind legal structure offers investors gaudy distribution yields and tax-saving advantages. They boomed alongside fracking, enjoying spectacular growth between 2009 and 2014. MLPs used to exhibit a high correlation with utilities, but since the 2014 oil bust, they have performed in step with the rest of the energy sector. Improved valuations have recently put MLPs back on investors’ radar. However, structural impediments and heterogeneous balance-sheet quality argue against broad index exposure. Investors would be better served by concentrating their efforts on picking individual stocks. Opportunities reside within smaller-cap MLPs and MLPs exposed to the Permian basin. Feature Dear Client, In place of a Weekly Report written from South Africa, where I have been meeting with clients, we are sending you this Special Report on Master Limited Partnerships (MLPs), written by my colleague Jennifer Lacombe.* Like mortgage REITs, which U.S. Investment Strategy followed from 2011 to 2013, MLPs are a yield play that investors might find to be an appealing bond alternative. We trust that you will find this report interesting and informative. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy * This report was initially published by our Global ETF Strategy service on November 15, 2018. It has been lightly revised to update charts and reflect subsequent market developments.   Q: What are MLPs and their tax benefits? Master Limited Partnerships (MLPs) are publicly listed partnerships involving two classes of partners. A General Partner (GP) controls the assets and manages the daily operations of the business. Limited Partners (LPs) - and public investors - provide the capital and collect cash flow distributions. Unlike corporations, which pay corporate taxes on their income, MLPs have the ability to pass through all of their income to their owners, along with deductible items like amortization and depreciation expenses. MLP investors, in turn pay income tax at their own individual marginal tax rates. MLP owners are thereby shielded from the double taxation that would otherwise apply when the corporation paid taxes on its income, and the shareholder paid taxes on the dividend distributed from the corporation’s income. Q: Why are they predominantly found in the energy sector? Concerns about the potential loss of federal income led Congress to limit MLP eligibility to companies in the energy and real estate sectors when it overhauled the tax code in 1986. Since the 1986 Act took effect, MLPs have had to generate at least 90% of “qualifying income” from their energy or real estate operations. Section 7704 of the Internal Revenue Code defines “qualifying income” as income derived from exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Over the years, the shale revolution and the rise of new technologies, such as horizontal drilling and fracturing, created elevated demand for energy infrastructure. Today, MLPs almost exclusively operate in the natural resources space (Chart 1). Chart 1 Q: Why did MLPs outperform assets of all stripes following the Great Financial Crisis? A combination of several factors led MLPs to record stunning returns between 2009 and 2014. The Alerian MLP Total Return Index grew by a whopping annualized rate of 38% during that time. Decreasing interest-rate environments are typically supportive of yield plays’ outperformance. Powered by high single-digit to double-digit distribution yields, MLPs led Treasuries, utilities stocks, high-yield bonds and even the S&P 500 over that six-year stretch (Chart 2). With the shale revolution in full swing, sustaining strong demand for pipelines and other energy infrastructure, investors’ funds flowed abundantly into the energy MLP space (Chart 3). Prices - a mathematical function of multiples and earnings - soared as money kept pouring in and P/E tripled in the first 7 years following the Great Financial Crisis (Chart 4). Chart 2Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays   Chart 3Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money...   Chart 4...Sending Multiples Soaring ...Sending Multiples Soaring ...Sending Multiples Soaring Q: Why has such outperformance not attracted more institutional and foreign investors? Because of U.S. tax rules, MLPs are relatively unattractive to tax-exempt investors and non-U.S. investors. The tax rule for U.S. tax-exempt investors – institutional investors such as pension funds, university endowments, charities and IRAs – treats MLP earnings as unrelated business taxable income (UBTI), making them subject to income tax. Moreover, to retain their own pass-through status and tax shield, open-ended funds – like many mutual funds and ETFs – can allocate no more than 25% of their total holdings to MLPs, and no more than 10% to a single MLP. U.S. tax rules consider foreign owners of MLPs to be engaged in a business in the U.S., and require them to file and pay U.S. federal income tax. Therefore, only U.S. individuals can truly reap the full benefits of the MLP structure. Though they easily access these securities on public exchanges, the tax shield comes at the price of convoluted accounting treatments. Unitholders receive Schedule K-1 tax forms that can be complicated enough to result in significant accounting costs. They are most suited for high net worth investors’ portfolios, although smaller investors who are not daunted by accounting burdens have also embraced the vehicle. Q: Why are MLP yields so high? The typical MLP partnership agreement incentivizes a GP to distribute all available cash to unitholders, after retaining reserves for business operations and liabilities. Not only does the corporate tax exemption increase the amount of available cash, but the General Partner also has wide discretion over the amount of retained reserves. Because distributions are the main determinant of any yield play’s performance, GPs have historically emphasized distribution yields – sometimes at the expense of retained earnings. The more assurance investors have that they will receive reliable cash flows, the better the MLP will perform in the market. Q: Do MLPs trade like other bond proxies? The distribution model worked beautifully during the shale-oil boom. Low retained reserves never became an issue because MLPs collected steady revenues – a function of prices and volumes of oil or gas processed - and could fund distributions in excess of operating cash flow by issuing new debt or equity. Investors were so eager to invest that GPs found themselves at the controls of a positive feedback loop in which the more cash they distributed to investors, the more capital flowed in to fund even higher distributions. The infrastructure-heavy business model and high payout ratios echoed companies in the utilities sector and, indeed, MLP returns correlated strongly with utilities stocks. However, the discretion embedded in the MLP model reached a breaking point soon after the oil bust arrived in mid-2014. The price-led decline in revenues necessitated distribution cuts and severed the correlation with utilities (Chart 5). Chart 5A Utilities Proxy No More... A Utilities Proxy No More... A Utilities Proxy No More... Q: Were MLPs immune to energy price swings before the 2014 bust? Conventional investor wisdom maintains that MLPs are immune to commodity price swings in the aggregate because of their utility-like characteristics and because long-term contracts lock in selling prices. Actually, however, MLP revenue structures differ greatly from one line of activity to the other. Natural gas pipeline transportation accounts for a quarter of aggregate MLP activity. Prices per unit of volume transited are contractually locked in 5-to-20-year contracts, providing immunity to spot price moves during the entire duration of the contract. Storage (natural gas not immediately needed, or crude oil waiting to be refined) accounts for another quarter of aggregate activity and is subject to a similar pricing model as natural gas pipelines. Only the contract lengths are much shorter, ranging from 1 to 5 years. Petroleum pipeline transportation accounts for 44% of MLP activity. Contracts locking prices over the long run are not typical in this line of business. The Federal Energy Regulatory Commission (FERC) also imposes a yearly price increase amounting to the Producer Price Index for Finished Goods, plus a 1.23% adjustment. MLP revenue structures are therefore varied, and only natural gas pipeline transportation’s revenue streams - a quarter of the sector – are truly immune to fluctuations in spot prices, thanks to their long-term contracts. It follows that MLPs in aggregate are indeed correlated with energy price swings and trade closely in line with energy stocks (Chart 6). Chart 6...An Energy Proxy Instead ...An Energy Proxy Instead ...An Energy Proxy Instead Up until recently, their correlation to spot oil prices in particular was even more striking. However, they failed to match the 2017-18 recovery in oil markets (Chart 8). Because cash flow reliability is a key driver of the investment decision for any yield play, distribution cuts are bound to make any MLP investors skittish, and oil prices may have to enter an extended bull market before they overcome their fears (Chart 7). Chart 7   Chart 8...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery Q: So, how cheap are they now? Since its peak in the summer of 2014, the Alerian MLP Total Return index has declined by 38% and is now flirting with the two-standard-deviation-cheap zone (Chart 9). Their profit margins have also strongly recovered (Chart 10). Chart 9Cheap Valuations... Cheap Valuations... Cheap Valuations...   Chart 10...Amid Recovering Profit Margins ...Amid Recovering Profit Margins ...Amid Recovering Profit Margins Because of the infrastructure-heavy nature of MLPs, traditional valuation metrics such as price-to-earnings can be misleading. High depreciation charges have significant impacts on earnings. Cash flows are an appropriate measure as they best inform a firm’s ability to maintain its distributions. Q: Great! So which ETF should I buy? The Alerian MLP index’s low multiples and recovering profit margins are not sufficient endorsements in themselves. An index is not an investible vehicle and even the best of index-tracking instruments can only imperfectly replicate an exposure. In the MLP space in particular, structural impediments reduce the attractiveness of exchange-traded products. Because ETFs are subject to the previously mentioned 25% cap on MLP holdings, many supplement their portfolios with regular pipeline or infrastructure stocks. Although the overall fund provides a decent exposure to the energy infrastructure sector, the diluted MLP exposure does not offer distribution yields anywhere comparable to the yields direct MLP owners receive. An alternative is to opt for a C-corporation structure. The flagship Alerian MLP ETF (ticker: AMLP) falls into this category. This structure allows for an undiluted exposure to MLPs, all the while relieving an ETF shareholder from having to deal with the complicated and costly accounting treatment that direct MLP ownership involves. However, C-corporations are subject to corporate income taxes, which cancels out the tax benefits of investing in MLPs in the first place. The resulting cumulative tax drag on returns can become substantial over time (Chart 11). Chart 11 Investors seek MLP exposure for the high distribution yields made possible by tax advantages. A fund will indeed provide diversification and accounting relief, but at the cost of surrendering either some yield or some of the tax advantages. This is not to mention that the bulk of the exchange-traded vehicles are Exchange Traded Notes (ETNs). Unlike ETFs, they do not own any underlying shares or units of securities. Instead, they are instruments issued and backed by financial institutions. Even in the case of well-established lending institutions, we shy away from these types of products, as we are not keen on taking unnecessary counterparty risk. Many MLP exchange-traded products are also illiquid, or have not gathered a significant mass of assets under management. The expense ratios are also high in the MLP exchange-traded product space, a result of the complicated accounting treatment of K-1 forms that are borne by the ETF or ETN sponsor (Table 1). Table 1ETNs Constitute Two Thirds Of A Relatively Illiquid Universe MLPs: Not Your Typical Yield Play MLPs: Not Your Typical Yield Play Q: What about the flagship Alerian MLP ETF? It’s clearly well-established. The flagship Alerian MLP ETF (ticker: AMLP) tracks the Alerian MLP Infrastructure Index and has gathered close to USD 10bn of AUM under its belt since its inception in 2010. Amid all the above limitations, it is the only viable option. However, it comes with its own set of yellow flags. Because it tracks a market-capitalization weighted index, half of the fund’s assets under management are concentrated in its five largest holdings. As we go to press, these are Magellan Midstream Partners LP, Enterprise Products Partners LP, Energy Transfer LP, Plains All American Pipeline LP and MPLX LP. These companies’ distribution yields have recovered since the 2014 oil crash, but the question of the sustainability of these cash flows is of utmost importance. Although retained earnings are at all-time highs, so is the level of debt (Chart 12). The fact that 50% of the fund is concentrated in these top 5 constituents dilutes the diversification benefits of index investing. Chart 12Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Q: So, what are my options? The MLP universe is heterogeneous. Wide disparity in valuation (Chart 13), debt levels (Chart 14) and performance (Chart 15) indicate that opportunities reside further down the capitalization scale. Chart 13   Chart 14   Chart 15 Because an index is a weighted average, a heterogeneous market does not warrant broad-index exposure, especially when the smallest constituents offer the best opportunities. Amalgamation is always a process of blending wheat and chaff together, but in this case it disproportionately favors the chaff. Stock picking thrives against this backdrop. Our expertise does not extend to evaluating individual energy MLPs. We leave the honor of recommending the best-in-class opportunities to the professional bottom-up analysts, backed by thorough and diligent review of company fundamentals and management capabilities. Where we can add value is in the analysis of economic cycles and secular macroeconomic forces. Despite the sharp fall in prices over the past two months, brought about by the surprise eleventh-hour waivers granted to Iranian oil importers, BCA’s Commodity & Energy Strategy service believes the global oil market remains tight. Our strategists expect that oil prices will recover in 2019 as OPEC producers, Russia, and Canada reduce output by an aggregate 1.4 million barrels a day, and the Iran-driven supply glut is worked off. While a 2019 oil spike would be a tailwind to petroleum pipeline MLPs, surging production in U.S. shales – led by the Permian Basin in West Texas – means the new pipeline capacity being built to accommodate higher output will find a ready market. Regardless of what happens with prices, our energy strategists foresee a localized surge in demand for transportation and other midstream services in the U.S. shales. In line with IEA projections, they expect U.S. crude oil production to grow by approximately 1.3 million barrels a day in 2019 once the constraints imposed by a lack of pipeline capacity in the fecund Permian basin ease. MLPs positioned to resolve the transportation bottleneck should be able to count on a bright near-term future. “Location, location, location” applies to pipelines as well as real estate, and reinforces a bottom-up focus when selecting MLPs.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com

Highlights Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Our research suggests that the odds of a serious earnings contraction for Chinese investable stocks over the coming year are high. Stocks are only likely to bottom near the end of the earnings adjustment process, if the 2014-2015 episode is a guide. Despite reasonable relative valuation, the long-term downtrend in sales-to-GDP suggests that Chinese stocks may be a “value trap” even over a multi-year time horizon. Feature Over the past several months BCA’s China Investment Strategy service has focused heavily on the cyclical condition of China’s economy, and whether any “green shoots” are evident from the key indicators that we track. We noted in last week’s report that our leading indicator for China’s old economy continues to point to slower growth over the coming months,1 a conclusion that is generally supported by the December trade, money, and credit data. In today's special report we address six questions concerning the outlook for Chinese stocks in light of passive outperformance versus the global benchmark over the past 3 months. We highlighted in last week’s report that investors should not view recent outperformance as a positive cyclical sign for Chinese stocks, and our answers to the questions below will hopefully provide readers with a fuller understanding of our neutral stance over a 6- to 12-month time horizon. The bottom line of our analysis is that a cyclical (6-12 month) overweight stance toward Chinese investable stocks versus the global benchmark remains uncompelling until the earnings contraction that is likely to occur this year is well underway. Chinese stocks offer reasonable-to-good valuation relative to global stocks, but may be cheap for a reason even over a multi-year time horizon. We remain tactically overweight Chinese investable stocks in recognition of the fact that investors may bid up the market in the lead-up to a possible trade deal with the U.S., but a legitimate improvement in domestic fundamentals is likely needed before we recommend investors upgrade their medium-term equity allocation to China. Q: Are the market signals from China-related assets bullish or bearish for Chinese stocks? A: Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Chart 1 presents our market-based China growth indicator, its four asset class subcomponents, and the range between the strongest and weakest components. Table 1 shows the change in the indicator and its 17 individual components since December 10, when the indicator clearly broke out. Chart 1Largely Driven By EM Equity Relative Performance Largely Driven By EM Equity Relative Performance Largely Driven By EM Equity Relative Performance Both the chart and the table make it clear that the recent rise in the indicator is not uniform. While it is true that most of the individual components have improved over the past month, the equity components and two currency measures (the inverse of the dollar and Asian currencies), especially CNY-USD have accounted for most of the gains. Table 1(Anomalous) Equity Relative Performance Has Driven The Recent Improvement In Our MBCGI Six Questions About Chinese Stocks Six Questions About Chinese Stocks As we noted in last week’s report, the Q4 outperformance of Chinese / emerging market stocks has been passive in nature, meaning that they have outperformed simply because developed market equities have collapsed. This, in combination with the fact that the strongest currency components have been linked to declining interest rate expectations in the U.S., tell us that the aggregate indicator has largely risen due to a 1) generalized selloff in global risk assets, 2) perceptions of easier Fed policy, and 3) a modest improvement in sentiment concerning the U.S.-China trade war. While it would not normally be the case that a global equity selloff would cause the equity component of our indicator to rise, December was atypical because many China-related assets had already declined in advance of the selloff. Are the latter two factors noted above reason enough move to an overweight stance towards Chinese stocks over the coming 6- to 12-months? In our view, the answer is “not yet”. While easier U.S. monetary policy is certainly welcome (particularly given our view that a recession is unlikely), it is not yet clear that either of the negative factors waiting on Chinese stocks in absolute terms will be resolved over the coming year. The first factor is the trade war with the U.S. We agree that the odds of some sort of a deal that avoids further tariff imposition have risen significantly over the past two months, more than we anticipated in the lead-up to the G20 meeting in Argentina. However, given the deep, structural nature of the dispute between the U.S. and China, we think it is dangerous to pre-emptively act on an agreement that may not come or may take much longer to be reached than investors currently hope. This risk is in addition to what is likely to be a deceleration in export growth over the coming few months regardless of the outcome of negotiations, as the export front-running effect that has boosted trade volume over the past several months wanes. But as we address in the next question, the second negative factor impacting Chinese stocks is the upcoming impact of a slowing domestic economy on Chinese earnings, an effect that is not likely to be impacted by the changes in the global economy implied by financial markets since mid-December. Q: What is the outlook for Chinese earnings growth over the coming year? A: Our research suggests that the odds of a serious earnings contraction over the coming year are high. Chart 2 presents an update to a model for Chinese ex-tech (or “old economy”) earnings growth that is part of our analytical toolkit.2 The model paints a rosy outlook for earnings growth, suggesting that it is set to decelerate over the coming year but will continue to grow at a double-digit rate. Chart 2The Li Keqiang Index Suggests Ex-Tech Earnings Growth Will Stay Positive... The Li Keqiang Index Suggests Ex-Tech Earnings Growth Will Stay Positive... The Li Keqiang Index Suggests Ex-Tech Earnings Growth Will Stay Positive... However, one problem with the approach used in Chart 2 is the fact that we have used the Li Keqiang index (LKI) as the independent variable in the model. Historically the LKI has reliably led ex-tech earnings growth, but we have highlighted several times over the past few months that the index is currently being supported by trade front-running activity that is very likely to wane, a view that is strongly consistent with the very negative December trade data that was released earlier this week. Chart 3 presents a different approach, namely the prediction of the odds of a serious investable equity earnings contraction over the coming 12-months (defined as earnings growth falling below -5%). The statistical approach taken in Chart 3 (logistic regression) is similar to that often employed by researchers attempting to predict the odds of a recession, and the chart shows that the model successfully warned of the two major earnings contractions over the past decade. Crucially, the odds of a major contraction did not rise about the 50% mark in 2012, when investable earnings growth decelerated significantly and fell briefly into negative territory. Chart 3...But Other Measures Imply High Odds Of An Outright Contraction ...But Other Measures Imply High Odds Of An Outright Contraction ...But Other Measures Imply High Odds Of An Outright Contraction The current message from the model is clear: the odds of a significant earnings contraction over the coming 12-months are as high as 70%, implying that the deceleration in 12-onth trailing earnings growth shown in panel 2 of Chart 3 is likely to continue. Q: If earnings are set to contract, when will investors anticipate a recovery? A: Near the end of the earnings adjustment process (for investable stocks), if the 2014-2015 episode is any guide. Chart 4 presents some perspective on the issue of when investors are likely to anticipate an eventual bottom in earnings if a contraction does indeed occur. The chart shows the level of 12-month forward earnings for investable and domestic stocks, and circles at what point stocks in each market bottomed during the massive selloff in the Chinese equity market from 2014-2015. Chart 4The Forward Earnings Adjustment Process Has Yet To Begin The Forward Earnings Adjustment Process Has Yet To Begin The Forward Earnings Adjustment Process Has Yet To Begin The chart shows that the domestic market bottomed roughly halfway through the earnings adjustment process, whereas the investable market bottomed almost at the end of the process. The chart also shows that this adjustment process has barely begun, which (in combination with Chart 3) currently argues against a cyclically overweight stance towards global stocks. Q: In the developed world (particularly the U.S.), elevated profit margins are viewed as a potential risk to earnings over the coming few years. Is profit margin mean-reversion a risk in China? A: Based on the absolute level of profit margins, no. Relative to the history of poor profitability for Chinese stocks, yes. Chart 5 shows the 12-month trailing profit margins for global and investable Chinese stocks. It shows how global margins have now moved past their previous cycle highs, a circumstance that is even more extreme in the case of the U.S. Chart 5Chinese Profit Margins Are Very Low, But Very Elevated Relative To Their History Chinese Profit Margins Are Very Low, But Very Elevated Relative To Their History Chinese Profit Margins Are Very Low, But Very Elevated Relative To Their History Investable Chinese margins are very low, which at first blush implies less risk of a mean-reversion assuming a common mean. However, panel 2 shows that Chinese investable margins are as high relative to their own history as they are for global stocks, and they have followed a similar pattern over the past few years. This suggests that the central tendency for Chinese margins is indeed significantly lower than it is for the global benchmark, and that the risk of mean reversion is similarly elevated in the face of a major economic shock. How is it possible that Chinese investable ROE has been similar or even higher than that of the global benchmark, but that profit margins are substantially lower? The answer, with very high likelihood, is leverage. Panel 1 of Chart 6 shows ROE for both markets, whereas panel 2 shows ROE divided by the profit margins shown in Chart 5. Using the DuPont approach to decomposing ROE, ROE divided by profit margins is equal to sales over equity, or the product of the asset turnover (sales/assets) and leverage (assets/equity) ratios. Panel 2 shows that product of turnover and leverage is more than twice that of global stocks, implying that Chinese companies are either extremely efficient in the use of their assets to generate sales, or they are very highly levered compared with global stocks. Chart 6High Chinese ROE The Result Of High Leverage High Chinese ROE The Result Of High Leverage High Chinese ROE The Result Of High Leverage The latter is overwhelmingly more likely. We presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds,3 a situation that has been caused by persistent leveraging since 2010. Not only does this explain the low profitability of Chinese stocks, it also magnifies the risk of significant mean reversion beyond a 6-12 month time horizon if Chinese policymakers panic and aggressively stimulate credit to stabilize a slowing economy. Q: Are Chinese stocks relatively cheap? A: The domestic equity market, yes. The investable market, somewhat. We presented Charts 7 and 8 in our final report of 2018,4 which showed the following: The forward P/E ratio for both domestic and investable Chinese stocks has improved substantially over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been but, depending on the measure employed, usually haven’t been cheaper (at least over the past decade). The A-share market particularly stands out, with all four relative valuation measures near, at, or above their 2014 levels. Chart 7Chinese Stocks Have Become Cheaper In Absolute Terms… Chinese Stocks Have Become Cheaper In Absolute Terms... Chinese Stocks Have Become Cheaper In Absolute Terms...   Chart 8…And Relative To Global Stocks ...And Relative To Global Stocks ...And Relative To Global Stocks Since we published our December report, global stocks sold off severely, which has somewhat diminished the relative cheapness of investable Chinese stocks. But the bottom line for investors is that Chinese stocks are not expensive in absolute terms, relative to global stocks, or compared with the history of relative valuation. Q: Given reasonable-to-good valuation, are Chinese stocks a good long-term buy? A: Not necessarily. It is distinctly possible that Chinese investable stocks are an example of a “value trap”. When discussing equity valuations in our last report of the year, we also mused about whether Chinese stocks are a great long-term buy. We noted that valuation is normally a powerful predictor of 10-year future performance, but that deviations from this relationship can exist. Chart 9 shows a vivid example of such a deviation, by presenting the profile of investable and domestic equities versus U.S. and global stocks, all rebased to the start of the U.S. recession in December 2007. The chart shows that for every $100 invested in equities at the end of 2007, local currency prices have fallen to $52 for domestic stocks and $86 for investable stocks. This is in sharp contrast to $128 for global equities, and a whopping $176 for the S&P 500. Chart 9A (Largely) Lost Decade For Chinese Stocks A (Largely) Lost Decade For Chinese Stocks A (Largely) Lost Decade For Chinese Stocks Excessive Chinese stock market valuation at the end of the last economic cycle has certainly contributed to the divergence shown in Chart 9. But Chart 10 shows another, less discussed factor: Chinese fundamental performance has not kept up with GDP growth, in contrast to developed markets. The chart shows the indexed ratio of sales per share to nominal GDP growth for the U.S. and China, and highlights that the latter has not only trended downward over time but has collapsed over the past four years. Chart 10Are Chinese Stocks Really A Play On Higher Chinese Growth? Are Chinese Stocks Really A Play On Higher Chinese Growth? Are Chinese Stocks Really A Play On Higher Chinese Growth? At root, the secularly bullish narrative surrounding Chinese stocks is based on the fact that China’s rate of economic growth is considerably higher than that of the developed world. But if the fundamental performance of China’s listed equities cannot keep pace with the economy, are they such a compelling buy simply because they are not expensive? An alternative view is that Chinese stocks are cheap for a reason, i.e. that they are a value trap. In combination with the sizeable risks facing the Chinese economy from extremely elevated levels of corporate debt, the best answer that we can give investors looking out over a multi-year horizon is that Chinese stocks are a great long-term buy for those who do not share our structural concerns. On a risk-adjusted basis, we do not yet find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Weekly Report “Monitoring The (Weak) Pulse Of The Data”, dated January 9, 2019, available at cis.bcaresearch.com. 2 Owing to the recent changes to the global industrial classification system (GICS), the chart shows Chinese earnings growth excluding the information technology and communication services sectors. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report “Legacies of 2018”, dated December 19, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Corporates: The Fed is now clearly signaling a near-term capitulation to tightening financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. Country Allocation: Move to overweight (4 of 5) on both U.S. investment grade and high-yield corporates, while downgrading U.S. Treasuries to underweight (2 of 5). Upgrade euro area investment grade and high-yield corporates to neutral (3 of 5), while downgrading euro area governments to underweight (2 of 5). Upgrade emerging market U.S. dollar denominated debt (both sovereign and corporate) from maximum underweight to underweight (2 of 5). Feature We downgraded our overall recommended investment stance on global corporate debt to neutral on June 26 of last year.1 That decision reflected our concern at the time that less accommodative central banks, a rising U.S. dollar, weakening global growth momentum and intensifying U.S.-China trade tensions had all significantly worsened the near-term risk/reward tradeoff for owning corporate bonds. This accompanied a firm-wide call at BCA to pare back our recommended exposure to global equities for the same reasons. We now see an opportunity, driven by better value and diminished market volatility after the Fed has clearly signaled a pause on U.S. rate hikes (Chart of the Week), to go back to an overweight stance on corporate credit on a tactical basis (3-6 months). Chart of the WeekTime For A Pause In Corporate Spread Widening Time For A Pause In Corporate Spread Widening Time For A Pause In Corporate Spread Widening To be clear, we still see medium-term risks for corporate credit once global growth stabilizes and a resilient U.S. economy forces the Fed to restart the rate hikes in the latter half of 2019. A move to a restrictive stance by the Fed toward year-end, signaled by an inversion of the U.S. Treasury yield curve, will raise recession risks and be the eventual death knell for this credit cycle. In the meantime, corporate debt is likely to outperform government bonds, justifying a tactical overweight position. This mirrors the recent change in the BCA House View, returning to a tactical overweight stance on global equities. On a regional basis, we prefer taking more of our upgraded credit risk in U.S. corporates over European and emerging market (EM) equivalents. The outlook for growth remains more favorable on a relative basis to Europe or China, the latter being most critical for the outperformance of EM assets. Why The Spread Widening Will Pause: A Patient Fed Is Taking A Break Global corporate bond spreads have widened since we did our downgrade in June, across all countries and credit tiers (Chart 2). Typically, some underperformance of corporate credit should occur when global growth momentum slows, as was the case throughout 2018. Yet the most violent period of spread widening only began once the Fed began signaling that it would continue with its interest hikes and balance sheet runoff, despite softening global growth. Chart 2 This set off yet another clash between policy and the markets – one of BCA’s key investment themes for 2018 that still applies in 2019 – resulting in a sharp selloff in global risk assets, including corporate debt. The result was a tightening of U.S. financial conditions, first through a stronger U.S. dollar (supported by rate hike expectations) and later through lower equity prices and wider corporate spreads. This echoed the 2014/15 period when the Fed was trying to lift rates off the zero bound after ending its quantitative easing program. The Fed was only able to deliver a single rate hike in December 2015 before pausing because of severely slumping global growth (most notably in China) and a sharp tightening in financial conditions, both of which knocked the wind out of the U.S. economy. Turning to 2019, the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) has reached levels last seen after that 2014/15 episode (Chart 3). Importantly, our global LEI diffusion index, which measures the number of countries with rising LEIs compared to falling LEIs and is itself a reliable leading indicator of the global LEI, is bottoming out at the same level that preceded the 2016 LEI revival (middle panel). This suggests that a stabilization of the global LEI could unfold in the next few months, which would also signal a potential rebound in corporate credit returns (bottom panel). Chart 3Credit Returns Already Reflect Slowing Growth Credit Returns Already Reflect Slowing Growth Credit Returns Already Reflect Slowing Growth Given the many similarities between today and the 2014/15 backdrop, it is sensible to look for other indicators that accurately heralded the end of that period of spread widening to help time a potential increase in recommended exposure to corporates. Over the past several weeks, our colleagues at our sister BCA service, U.S. Bond Strategy, have been following a checklist of market-based signals to determine the timing of a potential peak in U.S. credit spreads.2 These are grouped into two categories: signals of rebounding global growth and signals of Fed capitulation on rate hikes. For global growth, the indicators monitored are shown in Chart 4: Chart 4Checklist For Peak U.S. Spreads: Global Growth Checklist For Peak U.S. Spreads: Global Growth Checklist For Peak U.S. Spreads: Global Growth the CRB raw industrials index of commodity prices (a broader measure that excludes highly volatile oil prices) the BCA Market-Based China Growth Indicator (created by our China Investment Strategy team as a proxy of investor expectations of Chinese growth3) the Global Industrial Mining equity price index For Fed capitulation, the indicators monitored are shown in Chart 5: Chart 5Checklist For Peak U.S. Spreads: Fed Capitulation Checklist For Peak U.S. Spreads: Fed Capitulation Checklist For Peak U.S. Spreads: Fed Capitulation our 12-month fed funds discounter, which measures the amount of expected Fed rate hikes over the next year discounted in the U.S. Overnight Index Swap (OIS) curve the price of gold in dollars (a higher price correlating with perceptions of easier U.S. monetary policy and vice versa) the nominal trade-weighted U.S. dollar index Among the growth-focused elements of the checklist, only the China Growth Indicator is in a clear uptrend. Non-oil commodity prices had been stabilizing at the end of 2018 but appear to be rolling over, while it is not yet clear if the downturn in Mining stocks has ended. With momentum in global PMIs and LEIs still having not yet bottomed out, it may be too early to expect a cyclical rebound in non-oil commodities and related equities. At a minimum, that will require even greater signs that China’s economy is regaining some vigor. However, as we discussed last week, Chinese policymakers’ options to stimulate growth are far more limited now than they were in 2015 and 2016 when a rebounding China boosted commodity demand and EM asset performance.4 Within the Fed-focused components of the “Peak Spreads Checklist”, the near-term bullish signal for credit is much stronger. Our fed funds discounter has rapidly priced out all rate hikes for 2019. Since November, gold is up nearly 8% and the nominal trade-weighted U.S. dollar is down 2%. The shift in recent Fed messaging from signaling a “gradual pace” of tightening to exhibiting “patience” on any future policy moves was a highly dovish signal for investors. This alone has been enough to stabilize equity and credit markets, which had been discounting that Fed tightening in 2019 would drive the U.S. into a possible recession. In the constant battle between financial conditions and the Fed, the former has won this latest round. How long will this Fed pause last? Continuing with the comparison to the 2014/15 episode, a critical difference is that underlying trends in U.S. economic growth and inflation are firmer today. This is evident in the BCA Fed Monitor, which is comprised of economic and financial data that indicate pressure on the Fed to tighten or ease monetary policy. Chart 6 shows a “cycle-on-cycle” comparison of the Fed Monitor (and its subcomponents) today versus 2014/15. The Fed Monitor is still signaling a need for the Fed to continue tightening because the Economic Growth and Inflation Components remain elevated. Yet the Monitor has declined from its recent peak thanks entirely to the plunge in the Financial Conditions Component, which has fallen even faster than it did in 2014/15. Chart 6BCA Fed Monitor: Today Vs 2014/15 BCA Fed Monitor: Today Vs 2014/15 BCA Fed Monitor: Today Vs 2014/15 The implication from our Fed Monitor is that there needs to be more evidence of slowing U.S. economic growth and reduced inflation pressures for the Fed to stay on hold for longer. If the data stay firm, but financial conditions ease because investors expect a prolonged pause from the Fed, then the Fed could quickly return to a hawkish bias later this year. This is now our base case scenario for how 2019 will play out. This is also why we are only upgrading corporate debt on a tactical basis. We do not expect U.S. growth or inflation to slow enough to prevent more Fed tightening later this year – an outcome that will weigh on credit returns as the Fed moves to a restrictive policy stance. Yet even if we are wrong and the U.S. economy decelerates more sharply, that is also a bad outcome for credit because it means weaker corporate profits and rising downgrades and defaults. For bond investors with longer-time horizons than 3-6 months, the credit rally that we are anticipating can actually provide an opportunity to reduce credit exposure for the final leg of the Fed’s monetary policy cycle and the multi-year corporate credit cycle. In other words, selling into the rally rather than chasing it. For now, we are choosing to play for the shorter-term move by upgrading our recommended global credit allocations. Yet we do not envision this turning into a long-term position. The medium-term outlook for corporates is far more challenging given the advanced age of the monetary, business and credit cycles. Bottom Line: The Fed is now clearly signaling a near-term capitulation to tightening global financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. The Specific Changes To Our Recommended Asset Allocation As part of our tactical upgrade of global corporate debt, we are making the following changes to our recommended portfolio allocation tables (see Page 13): Upgrade overall global credit exposure to overweight (4 out of 5) Upgrade both U.S. investment grade and high-yield corporate exposure to overweight (4 out of 5), while downgrading U.S. Treasury exposure to underweight (2 out of 5) Upgrade euro area investment grade and high-yield corporate exposure to neutral (3 out of 5) and downgrade euro area government bond exposure to underweight (2 out of 5) Upgrade EM U.S. dollar denominated debt from maximum underweight to underweight (2 out of 5), both for sovereign and corporate debt. The changes all represent a one-notch upgrade from our previous allocations, based on our more positive tactical view on overall global credit risk, while still maintaining our relative preference for U.S. corporates over non-U.S. equivalents. We prefer U.S. credit not only because we expect better relative economic growth momentum in the U.S., but also because our preferred valuation metrics indicate that U.S. corporate bond spreads now look relatively attractive. Our estimate of the default-adjusted spread on U.S. high-yield corporates, which is simply the current spread minus losses from defaults, has risen to 302bps, well above the long-run average of 268bps (Chart 7). That is a function of the high-yield spread now discounting a 2019 default rate of nearly 6%, well above our forecasted default rate of 2.5%.5 Chart 7Too Much Default Risk Priced Into U.S. Junk Too Much Default Risk Priced Into U.S. Junk Too Much Default Risk Priced Into U.S. Junk Corporate credit spreads in the U.S. also look attractive on a volatility-adjusted basis. Our estimates of Breakeven Spreads – the amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon – shows that credit spreads have cheapened to levels that are in the upper end of the historical range for both investment grade and high-yield debt (Charts 8 & 9). Chart 8Vol-Adjusted IG Spreads Have Cheapened Vol-Adjusted IG Spreads Have Cheapened Vol-Adjusted IG Spreads Have Cheapened   Chart 9Vol-Adjusted HY Spreads Are Cheap Vol-Adjusted HY Spreads Are Cheap Vol-Adjusted HY Spreads Are Cheap Credit spreads have also cheapened up in Europe and EM, and a “risk-on” rally from a Fed pause will likely benefit spread product in those regions. However, the performance of U.S. credit versus non-U.S. credit remains largely determined by relative growth trends (Charts 10 & 11). Given our more positive view on U.S. growth on a relative basis, we are maintaining a higher recommended allocation to U.S. corporates versus euro area and EM equivalents, even as we upgrade overall global corporate exposure. This is also a way to provide a partial hedge to the specific risks in the latter regions coming from: Chart 10Global Corporates: Continue Favoring U.S. Over Europe Global Corporates: Continue Favoring U.S. Over Europe Global Corporates: Continue Favoring U.S. Over Europe   Chart 11Global Corporates: Continue Favoring U.S. Over EM Global Corporates: Continue Favoring U.S. Over EM Global Corporates: Continue Favoring U.S. Over EM a) an end of the ECB’s corporate bond buying as part of its Asset Purchase Program, which takes a major buyer out of the euro area corporate market b) a more persistent slowing of Chinese growth momentum and softer non-oil commodity prices, both of which would be negatives for EM assets On a final note, we are also changing the specific weighting in our Model Bond Portfolio on Page 12 to reflect all of the above changes. The allocations to all U.S., euro area and EM corporates are increased – with bigger allocation changes in the U.S. – funded out of reduced weightings in U.S., German and French government bonds. Note that we are not making any changes to our relative U.K. exposures this week, given the unique risk for U.K. financial markets from the Brexit uncertainty. Thus, we are maintaining an overweight stance on U.K. Gilts in the government bond portion of the model portfolio, while remaining underweight U.K. corporates on the credit side.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral”, dated June 26th 2018, available at gfis.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27th 2018, available at usbs.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21st 2018, available at cis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “Three Big Questions To Start Off 2019”, dated January 8th 2019, available at gfis.bcaresearch.com. 5 That forecasted default rate is taken from Moody’s, who have a similarly positive outlook on 2019 U.S. growth as BCA. Therefore, we see no reason to use a different default rate assumption in our high-yield valuation estimate. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1  However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Corporate Bonds: Attractive Entry Point Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Fed Capitulation Indicators Send A Strong Signal... Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators ...While There Is Positive Movement In Global Growth Indicators ...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4  Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk China Is The One Key Risk China Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). Chart 5 It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward Financial Conditions Likely Going To Ease Going Forward Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening.  Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Inflation Remains Well Contained Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now Muted Inflationary Pressures For Now Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now Expect Higher Inflation Six Months From Now Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7  Chart 10Message From Our Adaptive Expectations Model Message From Our Adaptive Expectations Model Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics along with compelling valuations and technicals, all suggest it no longer pays to be bearish the S&P 1500 steel index. Boost to overweight. A marginally improving China monetary backdrop, a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Upgrade to a modest overweight. Recent Changes Boost the niche S&P 1500 Steel Index to overweight today. This move also lifts the S&P Materials Index to a modest overweight. Table 1 Catharsis Catharsis Feature The S&P 500 convulsed following the December 19th Fed meeting and suffered a cathartic 450 point peak-to-trough fall last month. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Chart 1).1 Chart 1Powell's Resolve Getting Tested Powell's Resolve Getting Tested Powell's Resolve Getting Tested The top panel of Chart 2 shows that the 2018 peak in the SPX occurred one week prior to the September Fed meeting. That meeting, when the Fed raised rates for the third time that year, was the straw that broke the camel's back. Indeed, the bond market has been signaling that the U.S. economy has reached the neutral rate last year, as the 10-year UST yield stalled near the 3.10% mark on several occasions (middle panel, Chart 2). Chart 2Fed Policy Mistake Fed Policy Mistake Fed Policy Mistake Our recent research also suggests that the Fed’s tightening cycle (from trough-to-peak) is now above the historical median and at least a pause is warranted.2 To put last year’s discount rate increases into further perspective, bottom panel of Chart 2 shows that a 100bps increase in the fed funds rate caused a roughly 30% collapse in the forward P/E. Not only is this multiple compression overdone, but prices also corrected 19% from peak-to-trough, likely paving the way for a smart recovery. Our running assumption remains that the U.S. economy will avoid recession this year and EPS will continue to expand. True, the yield curve inversions have widened beyond the 5/3 and 5/2 slopes to the 7/1, and we heed the bond market’s message (Chart 3). However, as we highlighted last month, yield curve inversions occur before stock market peaks. Keep in mind that the most important yield curve slope, the 10/2, has not yet inverted. The upshot is that the SPX has yet to peter out for the cycle.3 Chart 3Yield Curve Inversion Is Spreading Yield Curve Inversion Is Spreading Yield Curve Inversion Is Spreading With regard to our end-2019 SPX target we are revising our base case scenario to 3,000 (from 3,150 previously),4 based on a 2020 EPS revision to $181 (from $191 previously),5 but we are sustaining the multiple at 16.5 times (Table 2). Assuming 2018 EPS end near $162, this represents a 6% EPS CAGR, in line with the still mid-single digit expansion signal from our EPS growth model (Chart 4). Table 2SPX EPS & Multiple Sensitivity Catharsis Catharsis Chart 4EPS Growth Model Still Expects Mid-Single Digit Expansion EPS Growth Model Still Expects Mid-Single Digit Expansion EPS Growth Model Still Expects Mid-Single Digit Expansion Adding it up, stocks hit rock bottom late-last year and a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome catalyst; any positive news on the trade tussle front with China will also act as a tonic for stocks, especially beaten down deep cyclicals. This week we are upgrading a U.S./China trade war GICS1 sector victim to a modest overweight position, via boosting a niche deep cyclical sub-index to an above benchmark allocation. Made Of Steel We are booking gains of 2.3% in the niche S&P 1500 steel index and boosting it from underweight all the way to an overweight stance. Beyond the contrary buy signal that bombed out technicals and depressed valuations are sending (Chart 5), there are high odds that relative profit outperformance is in the early innings. Chart 5Steel Is A Steal Steel Is A Steal Steel Is A Steal While U.S. steel stocks should have benefitted enormously from the U.S./China trade war and steel import tariffs, China macro dictates the fate of the S&P 1500 steel index. China’s waning fiscal and credit impulses have weighed heavily on U.S. steel stocks (top panel, Chart 6). Chinese authorities have been trying to engineer a soft landing, but the Chinese manufacturing PMI has now dipped below the boom/bust line (middle panel, Chart 6). Chart 6Mixed China Signals... bca.uses_wr_2019_01_14_c6 bca.uses_wr_2019_01_14_c6 Nevertheless, the recovering Li KEQIANG index is sending a positive signal (bottom panel, Chart 6). In addition, recent news of a mini fiscal package centered on high speed rail infrastructure spending is a step in the right direction. Historically, Chinese infrastructure outlays and relative share prices have been joined at the hip (middle panel, Chart 7). Chart 7...But Monetary And Fiscal Taps Are Opening ...But Monetary And Fiscal Taps Are Opening ...But Monetary And Fiscal Taps Are Opening On the monetary front, the easing in the banks’ reserve-requirement-ratio (RRR), albeit with a delayed effect, should also aid infrastructure spending uptake (RRR shown inverted, bottom panel, Chart 7). Similarly, the steepening in the Chinese yield curve underscores that easing financial conditions are conducive to a pickup in capital outlays (top panel, Chart 7). The U.S. dollar is another important macro variable driving U.S. steel stocks performance. The greenback’s steep appreciation since April 2018 has dealt a dual blow to domestic steel producers: not only is the underlying commodity quoted globally in U.S. dollars, but also FX translation losses have dented sector profitability. Despite the grim U.S. dollar news, there is light at the end of the tunnel. Were the Fed to pause its hiking cycle, at least in the front half of the year, the greenback’s advance may go on hiatus. Importantly, J.P. Morgan’s EM FX index is staging a comeback and steel prices are holding their own (top and bottom panels, Chart 8). Chart 8Bright Profit Drivers Bright Profit Drivers Bright Profit Drivers On the domestic front, news is also encouraging. Ever since President Trump came into power, blast furnaces have been running around the clock. Industry resource utilization rates are in a V-shaped recovery since 2016 and only recently returned to levels last seen prior to the Great Recession (middle panel, Chart 8). Steel new order growth is running at a healthy clip and is even surpassing inventory accumulation. This bright demand backdrop is a boon for steelmaking earnings (Chart 9). Chart 9Domestic Operating Backdrop... Domestic Operating Backdrop... Domestic Operating Backdrop... With regard to the domestic demand front, while automobile sales have been flirting with the zero growth line for the better part of the past three years, non-residential construction has been a primary beneficiary from the easing in fiscal policy (bottom panel, Chart 10). Fiscal thrust will continue to goose the U.S. economy in 2019, according to the IMF’s October 2018 World Economic Outlook update, and a new infrastructure spending bill, however modest, will, at the margin, buoy steel profits. Finally, according to the Fed’s latest Senior Loan Officer Survey, bankers are far from constricting the flow of credit toward the key end-demand segments, autos and commercial real estate. Chart 10...And Domestic Demand Will Buoy Steel Profits ...And Domestic Demand Will Buoy Steel Profits ...And Domestic Demand Will Buoy Steel Profits In sum, compelling valuations and technicals, the budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics, all suggest that it no longer pays to be bearish the S&P 1500 steel index. Bottom Line: Lift the S&P 1500 steel index from underweight to overweight and lock in gains of 2.3%. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS. Time To Dip Into Materials Raising the S&P 1500 steel index to an above benchmark allocation shifts the S&P materials sector into the overweight column. China macro dominates the direction of U.S. materials stocks. On the monetary front, the easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 11). Chart 11Buy Materials As China's Monetary Spigots Are Loosening Buy Materials As China's Monetary Spigots Are Loosening Buy Materials As China's Monetary Spigots Are Loosening The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNYUSD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 11). Beyond the budding recovery in some key Chinese data (bottom panel, Chart 12), the troughing in emerging markets (EM) currencies versus the greenback also suggests that U.S. materials stocks have put in a bottom (top panel, Chart 12). Chart 12Shifting EM Internals Are A Boon For Materials Shifting EM Internals Are A Boon For Materials Shifting EM Internals Are A Boon For Materials The EM stock outperformance compared with the global benchmark (second panel, Chart 12) along with EM market internals corroborate the EM FX message. In more detail, EM Latin American equities have been significantly outperforming EM Asian bourses. This real time proxy of commodity producers versus consumers has been an excellent indicator of relative share prices and the current message is to expect more relative gains in the S&P materials sector (third panel, Chart 12). On the earnings front, while last year’s trade dispute related collapse in relative share prices is signaling profit trouble in the coming months, our EPS growth model (comprising the U.S. dollar, interest rates and commodity prices) has ticked up. Similar to the 2012 and 2016 lows, there are good odds that our model is picking up a soft landing in profits (second panel, Chart 13). Chart 13Profit Growth Model Has Troughed Profit Growth Model Has Troughed Profit Growth Model Has Troughed S&P materials sub-sector EPS breadth has slingshot higher compared with the overall market and relative long-term EPS growth forecasts are trying to bottom near the 2016 nadir (third & bottom panels, Chart 13). With regard to the sector’s financial health, materials’ indebtedness profile remains in recovery mode, still in the aftermath of the late-2015/early-2016 manufacturing recession with net debt-to-EBITDA in a free fall and a steeply accelerating interest coverage ratio. Capital outlays are also expanding smartly and are now on an even keel with sales growth (Chart 14). Given this improvement in corporate health, there are low odds of debt-related materials sector deflation. Chart 14Clean Bill Of Corporate Health Clean Bill Of Corporate Health Clean Bill Of Corporate Health Taking the pulse of investor sentiment toward this niche deep cyclical sector reveals that technical conditions are as oversold as can be; in fact our Technical Indicator sits at one standard deviation below the historical mean, a level that has preceded previous recovery rallies (Chart 15). Chart 15Contrary Buy Alert: Under-owned... Contrary Buy Alert: Under-owned... Contrary Buy Alert: Under-owned... Finally, according to our Valuation Indicator, relative valuations have crumbled to the lowest level since the GFC, and even relative EV/EBITDA has also corrected to the historical mean (Chart 16). Chart 16...And Unloved ...And Unloved ...And Unloved Netting it out, a marginally improving China monetary backdrop along with a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Bottom Line: Lift the S&P materials sector to a modest overweight position.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Will The Market Test Powell?” dated November 13, 2017, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Lifting SPX Target” dated April 30, 2018, available at uses.bcaresearch.com. 5      Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

The oil rout that began in October appears to have run its course, based on positioning, sentiment and technicals. All the same, several cross-market gauges we designed to assess investors’ conviction on global macro conditions continue to support a cautious view over the short term. This dichotomy in the markets’ internal dynamics supports our view volatility will remain elevated over the next month or two. After that, we expect clear evidence the global oil market is tightening, as strong OPEC 2.0 compliance with production cuts and robust demand – albeit weaker than that of the past two years – drains inventories in 1H19. This is the basis of our $80/bbl Brent forecast for this year. Highlights Energy: Overweight. Our oil recommendations made last week in the wake of the oil-price vs. fundamentals disconnect – long spot WTI and long July 2019 Brent vs. short July 2020 Brent spread – are up 5.7% and 0.7%. Base Metals: Neutral. Asia trade-volume growth likely will move lower in the short term, even if Sino – U.S. trade talks are fruitful. With or without such an outcome, precautionary inventories built on both sides will have to be drawn down, an outcome we believe is priced into base metals prices. A rapprochement would be supportive for these markets, but these inventories still have to be worked through. Precious Metals: Neutral. Gold’s rally is intact, as markets gain conviction the Fed will deliver one rate hike this year. We are aligned with our House view calling for three hikes, which would present a headwind. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Insiders report China made three large purchases of soybeans from the U.S. over the past month, as trade negotiators met in Beijing this week. Optimism on the trade front is buoying optimism in ag markets.1 Feature The rout in oil prices over the course of 4Q18 appears to have run its course, based on a composite indicator we created to assess technical and sentiment information in the crude oil market, and other metrics designed to gauge internal market dynamics (Chart of the Week). Chart of the WeekBCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude The individual components of the composite at the end of last year all had taken a sharp down leg, indicating investors were seriously concerned about a global slowdown and perhaps even an unexpectedly early recession (Chart 2).2 This concern also was noted by the World Bank, which this week revised its EM growth outlook – the key driver of commodity demand – for 2018 lower, and shaved its global 2019 growth estimate as well.3 Chart 2Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Ordinarily, there is not a lot of econometric support for technical indicators. Nonetheless, we found this composite indicator does a good job of explaining y/y changes of Brent crude oil prices, and vice versa. That’s right: there is two-way Granger-causality between the BCA WTI Composite indicator and y/y crude prices (Chart 3).4 Chart 3Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Given this two-way relationship, it is plausible speculative positioning, investor sentiment and price momentum can help forecast short-term price movements. In turn, the movement in prices feeds back to the components of our composite indicator, and can help anticipate positioning, sentiment and momentum. Indeed, it is likely the fundamental supply-side shock arising from the higher-than-expected waivers on Iranian imports granted by the Trump administration in November – separate and apart from the selling pressure in October – set off one of these feedback loops. Given the paucity of data at the time, market participants had to guess the extent of the physical surplus arising from the waivers as OPEC 2.0 rapidly increased production and filled inventories ahead of U.S. sanctions, and at the same time fears over the strength of demand were becoming more pronounced.5 As we noted last week, we do not think the oil price rout was evidence of an as-yet undetected collapse in demand or run-away supply. OPEC 2.0 and Canadian producers will cut ~ 1.4mm b/d of production; decline-curve losses of ~ 200k b/d from states that cannot maintain or increase their supply will persist, and slower U.S. shale growth resulting from price-induced capex declines will reduce output growth there. These supply cuts, plus still-strong demand growth of 1.4mm b/d, are driving our forecast the physical oil overhang will clear in 1H19, and that Brent prices will average $80/bbl this year, with WTI trading $6/bbl below that.6 Based on the most recent “oversold” reading of the BCA WTI Composite indicator, we believe the oil rout has run its course, given the indicator is in deeply oversold territory. By now, we think the negative sentiment and spec positioning components of prices have been exhausted. Unless we see a fundamental shock – a truly unexpected collapse in demand, e.g., or a complete breakdown in OPEC 2.0 production discipline – it is difficult to foresee another sell-off.  As the uncertainty clears and inventory starts to draw, speculators will re-enter the market (allowing producers to hedge), and sentiment will turn more bullish as visible evidence of lower inventories continues to be reported in weekly and monthly data. Some Indicators Still Urge Caution While the case can be made the oil rout has run its course, there still are cautionary signals flashing in our other indicators that assess internal market dynamics within and across EM and commodities. This likely will keep volatility high over the short term (Chart 4). Chart 4Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated BCA’s Emerging Market strategists’ Risk-on vs. Safe-Haven currency ratio has rolled over. This ratio picked up the degradation of demand expectations and rise in recession fears, which then spilled into global bond yields. With the benefit of hindsight, the case can be made this presaged a rise in global risk aversion in currency markets (Chart 5).7 Chart 5Warning Signs Flashing bca.ces_wr_2019_01_10_c5 bca.ces_wr_2019_01_10_c5 In addition, our gold ratios, which serve as growth-versus-safe-haven indicators – i.e., the copper/gold and oil/gold ratios – sagged, as industrial commodities weakened and gold rallied by 7% since November 2018.8 Together, these indicate markets were revising down their growth expectations, and reducing their risk in 4Q18. Even with the recent pick up in EM trade volume – a proxy for EM income growth – our short-term models suggest this likely will not be sustained, and that import volume growth will contract in 2H19 (Chart 6). Chart 6Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Our EM trade-volume models are driven by the broad trade-weighted USD (TWIB) and other FX and financial variables.9 The USD had been rallying as the U.S. domestic economy outperformed the rest of the world, and markets remained concerned over the Fed’s rates-normalization policy, which was pressuring expectations for EM trade growth lower. With the oil-price collapse of 4Q18 in the rear-view mirror, it is not inconceivable the Fed will not feel compelled to raise rates in 1H19, as inflation expectations are re-calibrated in the wake of this most important expectations driver. If this takes some of the steam out of the USD, or even causes it to retreat from its recent highs, oil – and commodities generally – will rally on the tailwind. Indeed, a depreciation in the USD of 5% from current levels could lift prices by ~18%, holding everything else constant (Chart 7). Chart 7USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance Bottom Line: Our intra- and inter-market indicators are throwing off conflicting signals regarding the current state of global oil markets. On the one hand, our WTI Composite indicator shows oil is oversold, which supports our bullish outlook. On the other hand, markets currently are signaling a larger decline in global growth than we currently have in our oil forecast models. A larger-than-expected slowdown in oil demand growth – e.g., an additional loss of 200k b/d that took growth to 1.2mm b/d – would push our Brent forecasts down by ~ $4/bbl to $76/bbl this year. Nevertheless, uncertainty about the future path of oil supply and demand is elevated, and the distribution of possible price outcomes is wide, as our most recent forecast illustrates (Chart 8). We believe the combination of OPEC 2.0 production discipline and robust demand support a rebound in oil prices in 2019. We are keeping our 2019 Brent price target at $80/bbl. Chart 8Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “China buys more U.S. soy as officials meet for trade talks,” published by reuters.com January 7, 2019.com. 2      Each of the individual components is standardized to create the WTI composite indicator. We lack CFTC open-interest data to update the open-interest series, due to the U.S. government’s shutdown. 3      This is in line with our expectation, which is contained in our most recent balances and forecast update published last week.  Please see “Oil Volatility will Persist; 2019 Brent Forecast Lowered to $80/bbl.”  It is available at ces.bcaresearch.com.  The World Bank’s latest forecast can be found in its Global Economic Prospects, which is titled “Darkening Skies.”  It can be found at http://www.worldbank.org/en/publication/global-economic-prospects. 4      Clive Granger used standard statistics to show information contained in past realizations of one variable can be used to predict another variable’s value. Two-way causality indicates lagged values of both variables contain statistically significant information that allows past realizations of both to be used to predict the other’s value.  There is a huge literature on this topic.  For an excellent intuitive explanation of Granger causality, please see the discussion beginning on p. 365 of “Time Series Analysis, Cointegration, and Applications,” Clive Granger’s Nobel lecture delivered December 8, 2003 (https://www.nobelprize.org/uploads/2018/06/granger-lecture.pdf). 5      Please see “All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  It is available at ces.bcaresearch.com. 6      We would not be at all surprised if OPEC 2.0 overdelivered on production cuts, as it did in 2017 – 1H18. 7      Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 8      These gold ratios are discussed in detail in “Gold Ratios Wave Off ‘Red October’ … Iran Export Waivers Highlight Tight Market,” published by BCA Research’s Commodity & Energy Strategy November 8, 2018.  It is available at ces.bcaresearch.com. 9      For in-depth discussions of these models and our general approach to modeling EM trade volumes, please see “Trade, Dollars, Oil & Metals … Assessing Downside Risk,” published by BCA Research’s Commodity & Energy Strategy August 23, 2018.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2018 Image ​​​​​​​

Highlights Chart 1Checklist To Buy Credit Checklist To Buy Credit Checklist To Buy Credit The sell-off in spread product continued through the holiday season, but with spreads now looking more attractive, it is time to consider increasing exposure to corporate credit. Much like in 2015/16, spread widening is being driven by the combination of weaker global growth and the perception of restrictive monetary policy. With that in mind, we are monitoring a checklist of global growth and monetary policy indicators to help us decide when to step back in.1 With the market now pricing-in rate cuts for the next 12 months, monetary policy indicators already signal a buying opportunity (Chart 1). However, before increasing spread product exposure from neutral to overweight we are waiting for a signal from our high frequency global growth indicators. The CRB Raw Industrials index has so far only flattened off (Chart 1, top panel). It started to rise prior to the early-2016 peak in credit spreads. Investors should maintain below-benchmark portfolio duration on a 6-12 month investment horizon, and a neutral allocation to spread product for now. We expect to upgrade spread product in the near future as global growth indicators stabilize. Stay tuned. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 106 basis points in December. The index option-adjusted spread widened 16 bps on the month to reach 153 bps. Corporate bonds underperformed the duration-equivalent Treasury index by 320 bps in 2018, making it the worst year for corporate bond performance since 2011. Recent poor performance has restored some value to the corporate bond sector. The 12-month breakeven spread for Baa-rated debt has only been wider 37% of the time since 1988 (Chart 2). As a result, we are actively looking for an opportunity to increase exposure to corporate bonds. Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview To assess when to raise exposure from neutral to overweight, we are monitoring a checklist of indicators related to global growth and monetary policy.2 While current spread levels present an attractive tactical entry point, spreads may not re-tighten all the way back to their post-crisis lows. Corporate profit growth far outpaced debt growth during the past year causing our measure of gross leverage to fall (panel 4), but a stronger dollar and rising wage bill will weigh on profit growth in 2019. We expect gross corporate leverage to rise in 2019. Chart   Chart High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 366 basis points in December. The average index option-adjusted spread widened 108 bps, and currently sits at 498 bps. High-Yield underperformed the duration-equivalent Treasury index by 363 bps in 2018, making it the worst year for high-yield excess returns since 2015. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 394 bps, well above average historical levels (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 394 bps in excess of duration-matched Treasuries, assuming no change in spreads. If we factor in enough spread compression to bring the default-adjusted spread back to its historical average, then we get a 12-month expected excess return of 814 bps. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview For a different perspective on valuation, we can also calculate the default rate necessary for High-Yield to deliver 12-month excess returns in line with the historical average. As of today, this spread-implied default rate is 4.58%, well above the 2.64% default rate anticipated by Moody’s (panel 4). Junk bond value is definitely attractive, and as stated on the front page of this report, we are looking for an opportunity to tactically upgrade the sector. That being said, the uptrend in job cut announcements makes it likely that default rate forecasts will be revised higher in 2019 (bottom panel). At present, spreads appear to offer enough of a buffer to absorb these upward revisions. MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in December. The conventional 30-year zero-volatility spread widened 8 bps on the month, driven by a 7 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening in the option-adjusted spread (OAS). MBS underperformed the duration-equivalent Treasury index by 59 bps in 2018. The zero-volatility spread widened 12 bps on the year, split between a 10 bps widening in the OAS and a 2 bps increase in the option cost. Lower mortgage rates during the past two months spurred a small jump in refinancings, but this increase will prove fleeting. Interest rates are poised to move higher in 2019, and higher rates will limit mortgage refi activity and keep a lid on MBS spreads (Chart 4). Chart 4MBS Market Overview MBS Market Overview MBS Market Overview All in all, with higher interest rates likely to limit refinancings, and with mortgage lending standards still easing from restrictive levels (bottom panel), the macro back-drop for MBS remains supportive. Elevated corporate bond spreads currently offer a better opportunity than those in the MBS space, but the supportive macro back-drop means that there is very low risk of significant MBS spread widening during the next 12 months. We maintain a neutral allocation to MBS for now, and will only look to upgrade the sector as the credit cycle matures and it becomes time to adopt an underweight allocation to corporate credit. For the time being, corporate bonds are the more attractive play. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 31 basis points in December, and by 80 bps in 2018. Sovereign debt underperformed the Treasury benchmark by 77 bps in December and by 263 bps in 2018. Sovereign spreads still appear unattractive compared to similarly-rated U.S. corporate spreads (Chart 5). Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Foreign Agencies underperformed by 24 bps in December and by 152 bps in 2018. Local Authorities underperformed by 86 bps in December and by 75 bps in 2018. Domestic Agencies underperformed by 7 bps in December and by 6 bps in 2018. Supranationals outperformed by 3 bps in December and by 22 bps in 2018. In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.3 Those countries are Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 114 basis points in December, and by 17 bps in 2018 (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 2% in December, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of -49 bps. In contrast, municipal bonds have delivered annualized excess returns of +45 bps before adjusting for the tax advantage.4 We attribute the pattern of mid-cycle outperformance to the fact that state & local government balance sheet health tends to lag the health of the corporate sector. At present, our Municipal Health Monitor remains in “improving health” territory, consistent with an environment where ratings upgrades will outpace downgrades (bottom panel). Meanwhile, corporations are already deep into the releveraging process. Treasury Curve: Favor The 2-Year Bullet Over The 1/5 Barbell Treasury yields fell sharply in December, but with only minor changes to the slope beyond the 2-year maturity point. The 2/10 slope was unchanged on the month and currently sits at 17 bps. The 5/30 slope steepened 5 bps on the month and currently sits at 49 bps. The biggest changes in slope occurred for maturities less than 2 years, as a result of Fed rate hikes being completely priced out of the curve (Chart 7). Our 12-month Fed Funds Discounter fell from +44 bps at the beginning of the month to -11 bps currently. Meanwhile, our 24-month discounter fell from +41 bps to -23 bps. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview As a result of the sharp 1/2 flattening, the 2-year note no longer appears cheap relative to the 1/5 barbell (panel 4). Alternatively, we could say that the 1/2/5 butterfly spread is now priced for 15 bps of 1/5 steepening during the next six months (bottom panel). In fact, our yield curve models now point to bullets being expensive relative to barbells for almost every butterfly spread combination (see Tables 4 and 5). This means it is currently less attractive to initiate curve steeper trades than flattener trades. Despite the relatively low yield pick-up in steepener trades, we think they still make sense at the moment given that the Treasury market is discounting an economic outlook that is far too grim. As we discussed in our Key Views report for 2019, sustainable yield curve inversion is unlikely until later in the year, after inflation expectations are re-anchored around pre-crisis levels.5 As such, we maintain our recommendation to favor the 2-year bullet over the duration-matched 1/5 barbell.  TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 196 basis points in December, and by 175 bps in 2018. The 10-year TIPS breakeven inflation rate fell 26 bps on the month and currently sits at 1.71%. The 5-year/5-year forward TIPS breakeven inflation rate also fell 26 bps on the month and currently sits at 1.91%. Long-maturity TIPS breakeven inflation rates have fallen sharply alongside the prices of oil and other commodities during the past two months, as they continue to grapple with two competing forces: Falling commodity prices on the one hand, and U.S. core inflation that continues to print close to the Fed’s target on the other. Eventually, the decisive factor in the TIPS market will be core U.S. inflation continuing to print close to the Fed’s 2% target. This will drive both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates back into a range between 2.3% and 2.5%, once the headwind from weakening commodity prices has passed. This is reinforced by the fact that the 10-year TIPS breakeven inflation rate is now well below the fair value from our Adaptive Expectations Model (Chart 8).6 This model is based on a combination of long-run and short-run inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. In other words, the market will need to see core inflation print close to the Fed’s target for some time before deciding that it will remain there on a sustained basis. Chart 8Inflation Compensation Inflation Compensation Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 8 basis points in December, but outperformed by 13 bps in 2018. The index option-adjusted spread for Aaa-rated ABS widened by 6 bps on the month and now stands at 48 bps, 14 bps above its pre-crisis low. The excess return Bond Map on page 15 shows that consumer ABS offer greater expected returns than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The New York Fed’s most recent SCE Credit Access Survey showed a decline in consumer credit applications during the past year, as well as an increase in rejection rates. This is consistent with the observed uptrends in household interest expense and the consumer credit delinquency rate (Chart 9). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Going forward, consumer credit delinquencies will continue to rise from very low levels, but are unlikely to spike without a significant deterioration in labor market conditions. As such, we maintain a neutral allocation to consumer ABS for now, but our next move will likely be a reduction to underweight as consumer credit delinquencies rise further. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 62 basis points in December, but outperformed by 20 bps in 2018. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 14 bps on the month and currently sits at 92 bps (Chart 10). A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed’s Q3 Senior Loan Officer Survey showed that lending standards were close to unchanged and that demand deteriorated. All in all, a slightly negative macro picture for CMBS that will bear close monitoring in the coming quarters. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 15 bps in December, and by 2 bps in 2018. The index option-adjusted spread widened 4 bps on the month and currently sits at 60 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this sector continues to make sense. Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11   Chart 12   Table 4Butterfly Strategy Valuation (As Of January 4, 2019) Get Ready To Buy Credit Get Ready To Buy Credit   Table 5Discounted Slope Change During Next 6 Months (BPs) Get Ready To Buy Credit Get Ready To Buy Credit   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com Footnotes 1 Please see Charts 2A and 2B in U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 2 For the full checklist please see Charts 2A and 2B from the U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Risk assets have had a rough go of it since we last published on December 17th: Equities have been through the wringer, spreads have widened sharply, and the 10-year Treasury yield has tumbled to an 11-month low. We don’t put much stock in the talk that the Fed is about to go too far, … : We still judge that the fed funds rate is comfortably shy of its equilibrium level. The economy will decelerate this year, but fiscal stimulus will keep it growing above trend. … and even if market-unfriendly policies merit a lower equity multiple, … : A bull market in Washington uncertainty is a recipe for a lower multiple, and there are no signs that policy uncertainty will ebb any time soon. … we think the time has come to put our cash overweight to work: Equities priced in a lot of bad news when the forward multiple fell below 14. If earnings hold up like we think they will, a recovery to the mid-15s would deliver a double-digit gain, and that merits an equity overweight relative to cash and bonds. Feature Thanks to Christmas Eve and New Year’s Eve falling on Mondays, we haven’t published since December 17th. A lot has happened in those three weeks, starting with the FOMC’s final 2018 meeting. As we’ve gathered our bearings and tried to set a course forward through the volatility, we’ve asked ourselves several questions about markets, policy and the economy. This week’s report reviews those questions, including the ones the clients we met three weeks ago might want to ask now. Is the expansion coming to an end? Not just yet; we still think it has at least a year to run. Following several uninspiring releases, the Atlanta Fed’s GDPNow forecast of real final domestic demand has slipped to 3.3% from 3.8%, but it’s still 3.3%. That may seem too good to be true this late in the cycle, but that’s what 100 basis points of fiscal stimulus can do when injected into an economy already operating at full capacity. The IMF estimates there’s still another 40 basis points of stimulus coming in 2019, and we expect that that infusion will be enough to stave off the next recession until 2020 or beyond. Is the Fed about to make a policy mistake? We do not think so. Although the neutral, or equilibrium, policy rate is only observable after the fact, research from the head of the New York Fed holds that the FOMC is not on the verge of breaching the neutral threshold. The widely-followed Laubach-Williams model estimates that the real neutral rate is between 0.75 and 0.875%, or 2.75-2.875% in nominal terms.1 Our internal equilibrium fed funds rate model sees even more breathing room – it estimates that the (nominal) equilibrium rate is around 3%, and that it will rise to around 3⅜% by the end of the year. U.S. equities have been hypersensitive to perceived inflection points in monetary policy throughout the sell-off, which began roughly after Jay Powell said in an October 3rd interview that interest rates were “a long way from neutral.” Interestingly, though, the money market’s expectations never really budged. At the time of the Powell interview, it was pricing in a December hike to 2.50%, and a 40% chance of one more hike to 2.75%. It would take the probability of a 2.75% terminal rate up to 80% in early November, but it was again calling for a 40% chance of 2.75% when we were on the road during the two-day December meeting. It now puts the odds of an additional hike at just 4%, and says the Fed will have cut rates once by the middle of next year (Chart 1). Chart 1According To The Money Market, The Fed's Done According To The Money Market, The Fed's Done According To The Money Market, The Fed's Done We do not know what is behind the money market’s obstinacy, but we see an economy that has far more accommodation than it needs. While we think it’s inevitable that the Fed will tighten into a recession – that’s life with a blunt monetary policy instrument that works with long and uncertain lags – we don’t think it is on the verge of doing so. Fiscal stimulus will ensure that the U.S. economy grows above trend again this year, and there are no imbalances in housing2 or the other cyclical segments of the economy that would make the expansion particularly vulnerable (Chart 2). Elevated rates of job openings (Chart 3, middle panel) and job quits (Chart 3, bottom panel) indicate that the labor market will continue drawing in workers (Chart 3, top panel), supporting consumption and growth. Chart 2No Signs Of Overheating, ... No Signs Of Overheating, ... No Signs Of Overheating, ...   Chart 3... And The Jobs Outlook Is Strong ... And The Jobs Outlook Is Strong ... And The Jobs Outlook Is Strong You aren’t still calling for four rate hikes this year, are you? Let’s call it three, now that the market-driven tightening in financial conditions (Chart 4) has already done some of the work of cooling off the economy. We take the Fed at its word when it says its actions are data-driven, and we don’t think that it will pile on when credit spreads have shot up to their 2015 oil-collapse/shale-patch-distress levels (Chart 5) and equity prices have swooned. If credit spreads retraced meaningfully, and equities went back to making new highs, four hikes might come back into play. Conversely, if spreads continued to widen and took aim at their 2016 peaks, two hikes might become more likely than three. Given our expectations for spreads (they will not approach 2015-6’s quasi-recession levels, but corporate leverage is too high to support material narrowing), and equities (the S&P 500 will be hard-pressed to eclipse September’s high), our base case is three hikes. Chart 4Tighter, Yes; Tight, No Tighter, Yes; Tight, No Tighter, Yes; Tight, No   Chart 5Spreads Say It's 2015-6, ... Spreads Say It's 2015-6, ... Spreads Say It's 2015-6, ... Have the economic fundamentals really deteriorated that much over the last three months? Not that we can tell. There have been some high-profile data disappointments here and there, like the punk manufacturing ISM release last Thursday, but the overall message has been positive, and Friday’s jobs report was consistent with an economy growing above trend. The economic surprise indexes have been declining since November, but they’re not at levels that are anywhere out of the ordinary (Chart 6). Our earnings-per-share model still sees robust growth for corporate earnings (Chart 7). Chart 6... But The Data Beg To Differ ... But The Data Beg To Differ ... But The Data Beg To Differ   Chart 7Earnings Will Decelerate, But They Won't Contract Earnings Will Decelerate, But They Won't Contract Earnings Will Decelerate, But They Won't Contract We are as discomfited by the prospect of new trade barriers as any other economists, and we have eyed the divergence between U.S. acceleration and rest-of-the-world deceleration with increasing wariness. Even for an economy as comparatively closed as the U.S., decoupling is only a temporary phenomenon. We tend to equate global activity with global trade, and generally view developing economies as especially dependent on trade. It is still early days, but we have found it mildly encouraging that EM activity and EM equities have been outpacing their DM equivalents. The growth backdrop can’t be that bad if the emerging markets are perking up. Do you still think the S&P 500 has yet to make its highs? Maybe, but we wouldn’t bet on it. We view stock prices, P, as the product of expected earnings, E, and the multiple investors are willing to pay for those earnings, P/E. If our confidence in the expansion is not misplaced, and corporate earnings match analysts’ consensus bottom-up expectations of $174, topping September 20th’s 2,930.75 closing high will require a multiple approaching 17. If analysts project year-over-year EPS gains across all of 2020’s quarters, E will rise over the course of the year, reducing the P/E expansion needed to make a new high, but an assault on the peak cannot succeed without a meaningful re-rating from today’s multiple in the 14s. Although multiple expansion has played second fiddle to earnings growth (Chart 8, middle panel) across the nine-and-a-half year bull market, it declined nearly 30% peak-to-trough in 2018, and was entirely responsible for the fourth-quarter sell-off (Chart 8, bottom panel). While we think the de-rating has gone too far, the last three months have persuaded us that a return to the 18.8 peak is too much to ask. Our working hypothesis is that the equity market has decided that Washington has become enough of an impediment that the market multiple has to come off a couple of points. Markets hate uncertainty, and the policy climate is flat-out unsettled: the principal architect and guarantor of the international postwar order repeatedly threatens to topple that order; the U.S.-China showdown does not appear to be nearing a resolution; and both political parties seem willing to sacrifice the economy to gain an advantage in 2020. In the absence of new deregulatory initiatives or tax cuts to balance out the broadly investment-unfriendly instincts of several of D.C.’s power players, a poisonous partisan climate and a dysfunctional administration can no longer be ignored. Chart 8Earnings Built The Bull Market; De-Rating Almost Wrecked It Earnings Built The Bull Market; De-Rating Almost Wrecked It Earnings Built The Bull Market; De-Rating Almost Wrecked It Okay, so what do you do now? We upgrade equities to overweight with the cash we raised in mid-June when we downgraded them from overweight to neutral. Although we wouldn’t bet on the S&P 500 topping 2,931, it doesn’t have to do so to generate alluring prospective returns. From a 2,500 starting point, a target of 2,750, or $174 earnings at a 15.75 multiple, would generate a 10% capital gain. If the economy holds up in line with our base-case expectation, it’s hard not to like U.S. equities at current levels. We were eager to put our cash overweight to work as we watched equities gyrate in October and November, but the combination of December’s valuation reset and the improved equity outlook from our Global Investment Strategy colleagues’ MacroQuant model encourages us to pull the trigger now. More money is made when conditions, or perceptions, go from terrible to bad than when they go from good to great. As the approaching earnings season redirects attention to the solid fundamental outlook, and the Treasury secretary stops taking actions that make investors wonder if conditions are far worse than they feared, there is a path for perceptions to improve. Chart 9Spreads Have Overreacted Spreads Have Overreacted Spreads Have Overreacted We continue to hold to our view that markets are underestimating the potential for inflation, making Treasuries vulnerable, especially at longer maturities. We reiterate our recommendation to underweight bonds via an underweight in Treasuries, and to hold interest-rate duration below benchmark in all fixed-income categories. We continue to recommend a neutral weighting in credit-sensitive fixed income, as the spread widening is incompatible with projected defaults (Chart 9), but we are not counting on meaningful spread compression this late in the cycle.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 From the spreadsheet containing updated estimates of the baseline model described in “Measuring the Natural Rate of Interest,” by Thomas Laubach and John C. Williams, published in the November 2003 Review of Economics and Statistics, located at https://www.newyorkfed.org/research/policy/rstar, and accessed January 3, 2019. 2 We discussed housing at length in the November 19 and December 3, 2018 U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar,” respectively, available at usis.bcaresearch.com.